Smart contracts: how banks are making the connection


Transactions such as insurance or compensation payments, mortgages, even account openings are usually time-consuming, often enervating, because of the necessary legitimizations and checks. They would not have to be – if they were deposited as smart contracts. These are programmed, self-fulfilling contracts based on distributed ledger technology, one of the best-known implementations of which is blockchain technologies such as ethereum. Transactions are stored decentrally at all participants and cryptographically secured, so tampering is impossible. Since contract agreements are based on if-then logic, they are also programmable. Both the reconciliation of terms and conditions and the actions, such as payments, take place automatically, without the need for a check by a central clearing house.

Smart contracts: opportunity and threat for banks

What does this mean for financial service providers such as banks, whose business model is largely based on this clearing function?? A study by capgemini published in 2016 highlights the opportunities offered by the technology: high savings potential from which both financial service providers and customers can benefit, fast processing and risk reduction. The authors of the study expected mass-market deployment to begin in 2020, subject to regulation, security of blockchain technology and data protection. At the same time, the decentralization associated with DLT applications also threatens the core business models of banks by eliminating the role of intermediaries.

Almost four years later, after the first pilot projects at german banks, little movement is discernible in the area of smart contracts. There is rather a tense calm, while in parallel the universe of defi is developing faster and faster, especially ethereum-based defi apps. The apps use smart contracts to transfer classic financial transactions such as loans, bonds or interest payments to cryptocurrencies.

Here in germany, too, banks are aware of how fundamentally DLT and smart contracts will change processes in practically all industries. This is how z. B. The banking association in its position paper "wagen aufbruch"!"The german bundestag explicitly addresses this issue in the 2021 elections and emphasizes the importance of the digital euro for the competitiveness of germany and europe. The requirements for both the introduction of programmable currency and regulatory enhancements have been executed. And certainly rightly, the association is also pushing for equal treatment of banks and technology companies according to the principle of "same services, same risks, same rules".

Trading – even under uncertainty

It is true that the regulatory framework for DLT and cryptocurrencies has not yet been finalized; the EU's central regulation on "markets in crypto-assets" (mica), for example, is still in the process of being agreed upon. It is also not yet clear how and according to which technology the digital euro is to be programmed. But waiting for the final clarity would be the wrong approach. Because compliance with the regulations is not enough to be successful; it is also a question of ability, technical requirements and know-how. Building new competencies takes time. Even more than legal uncertainties, lack of standardization or immaturity of blockchain technology, the banking industry is concerned about the lack of its own resources: in a recent bitkom survey on blockchain technology, 85 percent of respondents cited a lack of qualified personnel and 91 percent a lack of know-how as challenges in blockchain use.

Build on core competencies

While "venturing forth" is exactly the right motto, many banks seem paralyzed. In this context, it is time to review and strategically leverage our own competencies. This includes many years of experience in business with bank customers as well as in meeting regulatory requirements. Compliance processes are firmly anchored in finance. For fintechs, on the other hand, it is precisely these regulatory requirements that are new. The biggest plus, however, is based on the position of trust: whether traded in digital or real euros, the real currency of a bank is the trust that both institutional investors and private users place in it.

This position of trust can also become a door opener in the world of digital currency. For even in a decentralized environment, a service is indispensable that requires the highest level of security and trust: private key custody. Users need these private cryptographic keys to access their crypto assets and transactions. Who, if not the trusted bank, would be better suited to provide this service?? Especially as many institutions already use cryptographic keys for other applications and therefore already have the necessary technical equipment. At the beginning of 2020, the crypto custody business was included in the german banking act as a new financial service. Banks can qualify for this through an approval process by bafin.

Cooperation and expansion of expertise

Building on this, the expansion of specific competencies and the development of viable use cases for smart contracts can be tackled. Attractive for customers is certainly the acquisition of digital shares – fully digitized and controlled via smart contracts – or the investment of new corporate accounts abroad.

This doesn't have to happen on its own; there are several reasons to open up, cooperate and partner:

  • Even within the bank itself, it is often necessary to overcome the silo-like separation between the legal and IT departments.
  • If a large majority in the industry states a lack of specialists and know-how, a merger into joint platforms is also conceivable, such as DLT project spunta of the italian banking association.
  • Partnerships with crypto-as-a-service or M&A providers offer more opportunities. An example of this is the takeover of kapilendo custodian, which was the second company in germany to be granted permission for crypto custody business, by hauck & aufhauser privatbankiers in september 2021. Such partnerships or acquisitions not only mean an immediate increase in competence, but also increase the attractiveness of a company for the sought-after IT specialists.
  • Developing smart contracts payment processing solutions for other industries requires close collaboration with the relevant stakeholders. The applications are many, from indemnity payments in rail and air travel, to leasing contracts, to logistics solutions and real estate management.
  • Specialized service providers can assist with regulatory requirements, status quo assessments, development of use cases and new solutions without the need to build up in-house resources in the institutions.

Not every project will be an immediate success. But even if a particular application does not turn out to be viable, other prospects open up as the project progresses. In any case, banks that venture into the world of crypto custody acquire new competencies in the new technologies of DLT and smart contracts, which are of great value for their further development and the progress of digitalization.

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